Magazine

U.S: Why Profits Will Stay Pleasingly Plump

May 14, 2006

One thing American business has been particularly good at in recent years is making money. At the end of last year, earnings for the companies in the Standard & Poor's 500-stock (MHP) index rose 14.4% above year-earlier levels. At yearend 2004, they were up 19.7%, after a 28.3% surge at the end of 2003. That run of impressive numbers has been remarkable for its power and breadth. That raises a crucial question for investors: How much longer will the party last?

Based on the solid performance so far in the first quarter, it might go on longer than you expect. At the end of April, with 334 of the S&P 500 companies having reported, 69% have announced earnings greater than analyst expectations at the beginning of the quarter, well above the 59% typical for any given quarter, according to Thomson Financial (TOC). After adding the results so far with the current expectations for companies that have not yet reported, Thomson says earnings would be up 13.4% from a year ago, beating the 12.1% gain analysts expected at the start of the quarter. And it's not just an energy windfall. Excluding the energy sector, earnings are on a path to grow 10.4%.

Moreover, Thomson says the earnings forecast from companies on their second-quarter projections, so far, is not bad at all. The ratio of negative to positive pre-announcements -- the number of companies saying earnings this quarter will fall short of forecasts divided by those saying profits will beat expectations -- is running well below the ratio at this same time last quarter and less than the long-term average.

Of course, one fact of life in the profits cycle is that earnings growth tends to slow as a business upswing ages. Demand cools, costs rise, and margins get squeezed. Those trends will eventually take hold. For now, though, this profits cycle is proving to be especially hardy, and any slowdown is more likely to be gradual than abrupt. That result would bode well for the overall economy, since profits are an important driver of capital spending, which correlates tightly with new jobs.

Earnings are holding up well for several reasons. First of all, revenue growth remains strong, because the economy isn't rolling over as meekly as some had feared. First-quarter economic growth, which clocked in at a robust 4.8% annual rate, was powered by broad gains in demand, including consumer spending, up 5.5%; business investment in new plants and equipment, up 14.3%; and exports, up 12.1%. Moreover, a slew of surprisingly strong reports for March and early April, ranging from capital goods orders to consumer spending to industrial activity, shows some momentum heading into the second quarter.

In particular, April surveys from the nation's purchasing managers show vigorous business activity for both manufacturers and nonmanufacturers. The Institute for Supply Management's composite index of industrial health rose to 57.3% in April, up from 55.2% in March. The reading is the highest since November and well above the first-quarter average. The purchasers noted that both output and employment grew faster, and that inventory growth picked up, suggesting another strong quarter for industrial production. The ISM's gauge for the large nonmanufacturing sector also rose strongly from March to April. It, too, exceeds its first-quarter level.

A second factor supporting the bottom line: Businesses are gaining pricing power, as suggested by the March pickup in inflation outside of energy. That could be an important influence on profit margins in coming months, especially to the extent that businesses can offset some of the pain from more expensive energy. Despite rising costs, companies continued to widen their margins in the first quarter, based on a further rise in the ratio of prices to unit labor costs. Margins are even wider now than the record readings reached at the peak of the earnings boom in 1997.

Expanding margins have been a key reason why earnings have been so strong. For example, among nonfinancial corporations last year, revenues rose 8%, but the profit margin on sales increased 18%, resulting in a 26% surge in earnings. As a business expansion ages and costs for labor, interest, and depreciation rise faster, margins grow more slowly, or even shrink. If margins don't increase, then earnings can't grow any faster than revenues. That's why profit gains eventually cool down.

This time, however, margins are not under as much pressure as in past business cycles. In particular, various nonlabor costs, such as those for interest expense and depreciation, have remained low, and they are not likely to speed up as rapidly as they have in past episodes.

Businesses have already taken the opportunity offered by low long-term interest rates to refinance their debt and reduce interest costs. So the Fed's hikes in short-term rates have had little bite. Interest expense has picked up over the past year, but its ratio to gross domestic product remains close to a three-decade low. Depreciation expense is being restrained by the relatively low ratio of capital spending to GDP, which fell sharply after the investment bust in 2000 and has not fully recovered.

The third -- and perhaps most important -- lift for both margins and overall earnings is the tight rein businesses are keeping on labor costs. Productivity gains continue to help in that effort. Through the first quarter, productivity is growing more slowly than it has in the past couple of years, but it is still increasing fast enough to offset much of the growth in charges for labor.

The key trend in labor costs, however, is not in the growth of wages and salaries, which are beginning to rise at a little faster clip. Businesses are keeping costs down by dramatically cutting the growth in what they shell out for their benefits programs, mainly by shifting more of the burden of paying for health care to workers.

Wages, salaries, and benefits, measured by the Labor Dept.'s employment cost index for private-sector workers, increased during the first quarter by a slim 0.6% from the fourth quarter. The yearly pace has fallen from 4% at the end of 2003 to a decade low of only 2.6%. Over that period, the yearly growth of wages and salaries has fluctuated between 2.3% and 3.1%, but the growth pace of benefits, which are about 30% of employment costs, has dropped from 6.5% to 3%.

The interesting result here is that businesses have new flexibility, not only to restrain their overall labor costs but also to adjust to the faster growth in wages that are required by a tighter labor market. That situation helps both company profits and consumer income.

In the coming year, as business costs for labor, interest, depreciation, and such continue to rise, profit growth is certain to moderate. Right now, industry stock analysts, always a bullish lot, expect a 12.8% advance for S&P 500 earnings per share for the 2006 calendar year, based on a Thomson Financial survey. The more cautious equity strategists see a gain of only 7.6%. Nevertheless, another double-digit year may not be out of the question.